Economics supply and demand

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Chapter 2

The Basics of Supply and Demand

Introduction

l What are supply and demand? l What is the market mechanism? l What are the effects of changes in

market equilibrium? l What are elasticities of supply and

demand?

Introduction

l How do short-run and long-run elasticities differ?

l What are the effects of government intervention – price controls?

Supply and Demand

l  Supply and demand analysis can: 1.  Help us understand and predict how real

world economic conditions affect market prices and production levels

2.  Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy

3.  Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers

Supply and Demand

l The Supply Curve m The relationship between the quantity of a

good that producers are willing to sell and the price of the good

m Measures quantity on the x-axis and price on the y-axis

m Linear case: , a<0, b>0

(P)QQ SS =

QS = a + bP

The Supply Curve

The supply curve slopes upward, demonstrating that

at higher prices firms will increase output

The Supply Curve, Graphically Depicted

Quantity

Price ($ per unit)

Q2 -a/b

1/b

QS = a + bP

P = − a b + 1b QS

The Supply Curve

l Other Variables Affecting Supply m Costs of Production

l Labor l Capital l Raw Materials

m Lower costs of production allow a firm to produce more at each price and vice versa

Change in Supply

l  The cost of raw materials (M) falls m Produced Q1 at P1 and Q0 at

P2 m Now produce Q2 at P1 and Q1

at P2 m Supply curve shifts right to S’

l  Algebraically:

l  EX:

Q1 Q0

S’

QS = a + b1P − b2M

QS = 1800 + 240P − 25M

The Supply Curve

l Change in Quantity Supplied m Movement along the curve caused by a

change in price l Change in Supply

m Shift of the curve caused by a change in something other than the price of the good l EX: Change in costs of production

Supply and Demand

l The Demand Curve m The relationship between the quantity of a

good that consumers are willing to buy and the price of the good

m Measures quantity on the x-axis and price on the y-axis

m Linear case: , a>0, b<0

(P)QQ DD = QD = a + bP

The Demand Curve

The demand curve slopes downward, demonstrating that consumers are willing

to buy more at a lower price as the product becomes

relatively cheaper.

Quantity

Price ($ per unit)

-a/b

1/b

QD = a + bP

P = − a b + 1b QD

The Demand Curve

l Other Variables Affecting Demand m Income

l  Increases in income allow consumers to purchase more at all prices

m Consumer Tastes m Price of Related Goods

l Substitutes l Complements

D P

D’

Change in Demand

l  Income Increases m Purchased Q0, at P2 and

Q1 at P1 m Now purchased Q1 at P2

and Q2 at P1 m Demand curve shifts right

l  Algebraically:

l  EX: QD = a + b1P + b2I

QD = 3550 − 266P + 50I

The Demand Curve

l Changes in quantity demanded m Movements along the demand curve caused

by a change in price l Changes in demand

m A shift of the entire demand curve caused by something other than price l  Income l Preferences

The Market Mechanism

l The market mechanism is the tendency in a free market for price to change until the market clears

l Markets clear when quantity demanded equals quantity supplied at the prevailing price

l Market clearing price – price at which markets clear

The Market Mechanism

The curves intersect at equilibrium, or market-

clearing, price. Quantity demanded

equals quantity supplied at P0

Q0 Quantity

Price ($ per unit)

The Market Mechanism

l In equilibrium m There is no shortage (excess demand) m There is no surplus (excess supply) m Quantity supplied equals quantity demanded m Anyone who wants to buy at the current price

can and all producers who want to sell at that price can

Market Surplus

l The market price is above equilibrium m There is excess supply à surplus m Creates downward pressure on price m Quantity demanded increases and quantity

supplied decreases m The market adjusts until new equilibrium is

reached…

The Market Mechanism

1.  At P1, price is above the market clearing price

2.  Qs > QD 3.  Price falls to the

market-clearing price

4.  Market adjusts to equilibrium

Surplus

Quantity

Price ($ per unit)

QS QD

Market Shortage

l The market price is below equilibrium: m There is excess demand à shortage m Creates upward pressure on prices m Quantity demanded decreases and quantity

supplied increases m The market adjusts until the new equilibrium

is reached…

The Market Mechanism

QS QD

Quantity

Price ($ per unit)

1.  At P2, price is below the market clearing price

2.  QD > QS 3.  Price rises to

the market- clearing price

4.  Market adjusts to equilibrium

Shortage

The Market Mechanism

l Supply and demand interact to determine the market-clearing price

l When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium

l Markets must be competitive for the mechanism to be efficient

Changes in Market Equilibrium

l Equilibrium prices are determined by the relative levels of supply and demand

l Changes in supply and/or demand will cause change in the equilibrium price and/or quantity in a free market…

S’

Changes in Market Equilibrium

l Raw material prices fall m S shifts to S’ m Surplus at P1: Q2 – Q1 m Price adjusts to

equilibrium at P3, Q3 l  Algebraically:

m Using values for a, b, b1, b2, and M, we can solve for P and Q(=QS=QD)

S D

Q3 Q1

QS = a + b1P − b2M QD = a + bP QS = QD

Outward parallel shift in supply

Changes in Market Equilibrium

l  Shift in supply could also come from an increase in wages (an inward parallel shift in supply) m Price rises from p1 to

p2, quantity demanded drops from Q1 to Q2.

S’ D

Q1 Q2

Inward parallel shift in supply

Changes in Market Equilibrium

l  Algebraic Example: (wage increases)

m Suppose wage rises from $10 to $12/hr. FIRST: What is equilibrium at $10 wage?

S’ D

3.46

2630 Q2

QS = 3300 + 240P −150w QD = 3550 − 266P

Inward parallel shift in supply

QS = QD → 3300 + 240P −150(10) = 3550 − 266P → 506P = 1750→ P = 1750506 ≈ $3.46 →Q = 3550 − 266(1750506 ) = 2630

Changes in Market Equilibrium

l  Algebraic Example: (wage increases)

m Now: What is equilibrium at $12 wage (after the increase)?

S’ D

2472

4.05

QS = 3300 + 240P −150w QD = 3550 − 266P

Inward parallel shift in supply

QS = QD → 3300 + 240P −150(12) = 3550 − 266P → 506P = 2050→ P = 2050506 ≈ $4.05 →Q = 3550 − 266(2050506 ) = 2472

3.46

2630

S D

Changes in Market Equilibrium

l  Income Increases m Demand increases to D’ m Shortage at P1 of Q2 – Q1 m Equilibrium at P3 and Q3

l  Algebraically:

m Using values for a, b, b1, b2, and I, we can solve for P and Q(=QS=QD)

Q Q1

D’

Outward parallel shift in demand

QS = a + bP QD = a + b1P + b2I QS = QD

S D

Changes in Market Equilibrium

l  Algebraic Example: (Advertising increases demand)

m Suppose advertising expenditures increase from $50 to $523. What is equilibrium at $50 in advertising? at $523?

Q Q1

D’

Outward parallel shift in demand

QS = 1800 + 240P QD = 3500 − 266P + A

D’ S’

Changes in Market Equilibrium

l  Income increases AND raw material prices fall m Quantity increases –

this is unambiguous m If the increase in D is

greater than the increase in S, price also increases l  Effect on price is

generally ambiguous when both D and S shift out…

Shifts in Supply and Demand

l  When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by:

1.  The relative size and direction of the change

2.  The shape of the supply and demand curves (slopes, intercepts, etc.)

Elasticities of Supply and Demand

l We are not only concerned with what direction price and quantity will move when the market changes, but also how much they change

l Elasticity gives a way to measure by how much a variable will change with the change in another variable

l Specifically, it gives the percentage change in one variable resulting from a one percent change in another…

Price Elasticity of Demand

l Measures the sensitivity of quantity demanded to price changes m It measures the percentage change in the

quantity demanded of a good that results from a one percent change in its price:

P QE DDP Δ

Δ= % %

Price Elasticity of Demand

l The % change in a variable is equal to the absolute change in the variable divided by the original level of the variable

l Therefore, elasticity can also be written as:

EP D = %ΔQ

%ΔP = ΔQ Q ΔP P

= ΔQ ΔP

P Q

Price Elasticity of Demand

l Usually a negative number m As price increases, quantity decreases m As price decreases, quantity increases

l When |EP| > 1, the good is price elastic m |%ΔQ| > |%ΔP|

l When |EP| < 1, the good is price inelastic m |%ΔQ| < |%ΔP|

EP D = %ΔQ

%ΔP = ΔQ ΔP

P Q

Price Elasticity of Demand

l The primary determinant of price elasticity of demand is the availability of good substitutes m If many good substitutes, demand is price

elastic l Can easily move to another good when the

price increases m Few substitutes à demand is price inelastic

Price Elasticity of Demand

l Looking at a linear demand curve, as we move along the curve ΔQ/ΔP is constant, but P and Q will change

l Price elasticity of demand must therefore be measured at a particular point on the demand curve

l Elasticity will change along the demand curve in a particular way…

Price Elasticity of Demand

l Given a linear demand curve m Elasticity depends on slope and on the

values of P and Q m The top portion of demand curve is elastic

l Price is high and quantity small m The bottom portion of demand curve is

inelastic l Price is low and quantity high

EP D = %ΔQ

%ΔP = ΔQ ΔP

P Q

Price Elasticity of Demand

Price

Ep = -1

Ep = 0

EP = -∞

Elastic

Inelastic Demand Curve

Q = 8 – 2P

à Elasticity =

ΔQ ΔP

= −2

Ed = −2 P Q

EP D = %ΔQ

%ΔP = ΔQ ΔP

P Q

Unit Elastic

Price Elasticity of Demand

l The steeper the demand curve, the more inelastic the demand for the good becomes

l The flatter the demand curve, the more elastic the demand for the good becomes

l Two extreme cases of demand curves m Completely inelastic demand – vertical m Infinitely elastic demand – horizontal

Infinitely Elastic Demand

D P*

Quantity

Price

EP = -∞

Completely Inelastic Demand

Quantity

Price

EP = 0

Other Demand Elasticities

l EX: Income Elasticity of Demand m Measures how much quantity demanded

changes with a change in income

EI =

%ΔQ %ΔI

= ΔQ / Q ΔI / I

= I Q

ΔQ ΔI

Price Elasticity of Supply

l Measures the sensitivity of quantity supplied given a change in price m Measures the percentage change in quantity

supplied resulting from a 1 percent change in price

EP S = %ΔQS

%ΔP

Elasticity: An Application

l Supply (wheat): QS = 1800 + 240P l Demand (wheat): QD = 3550 – 266P

Elasticity: An Application

QS = QD 1800 + 240P = 3550 – 266P

506P = 1750 P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million

bushels

Elasticity: An Application

l We can find the elasticities of demand and supply at this point

EP D = P

Q ΔQD ΔP

= 3.46 2630

(−266) = −.35

EP S = P

Q ΔQS ΔP

= 3.46 2630

(240) = .31

Short-Run Versus Long-Run Elasticity

l Price elasticity varies with the amount of time consumers have to respond to a price

l Short-run demand and supply curves often look very different from their long- run counterparts

Short-Run Versus Long-Run Elasticity

l Demand m In general, demand is much more price

elastic in the long run l Consumers take time to adjust consumption

habits l Recall that demand for a good is usually linked

to the availability of substitutes … m More substitutes are usually available in the long

run m EX: more fuel efficient cars makes price elasticity

for gasoline drop – eventually…

Gasoline: Short-Run and Long-Run Demand Curves

DSR

DLR

•  People cannot easily adjust consumption in the short run. •  In the long run, people tend to drive smaller and more fuel efficient cars.

Quantity of Gas

Price

Short-Run Versus Long-Run Elasticity

l EXCEPTION: Demand and Durability m For some durable goods, demand is more

elastic in the short run m If goods are durable, then when price

increases, consumers choose to hold on to the good instead of replacing it

m EX: If the price rises, I can hold onto my car longer. (If it drops, I can replace it sooner.)

m But eventually cars must be replaced…

DSR

DLR •  Initially, people may put off immediate car purchase •  In long run, older cars must be replaced à elasticity declines in long-run

Cars: Short-Run and Long-Run Demand Curves

Quantity of Cars

Price

Short-Run Versus Long-Run Elasticity

l Most goods and services: m Long-run price elasticity of supply is greater

than short-run price elasticity of supply m In long-run, fixed factors affecting supply can

be changed

SSR

Quantity Primary Copper

Price

Short-Run Versus Long-Run Elasticity

SLR

Due to limited capacity, firms are limited by

output constraints in the short run.

In the long run, they can expand.

Effects of Price Controls

l Markets are rarely free of government intervention m Imposed taxes and granted subsidies m Price controls

l Price controls usually hold the price above or below the equilibrium price m Excess demand – shortage m Excess supply – surplus

Effects of Price Controls

Quantity

Price

Pmax

•  Price is regulated to be no higher than Pmax •  Quantity supplied falls and quantity demanded increases •  A shortage results

QS QD

Shortage

Effects of Price Controls

l Excess demand sometimes takes the form of queues (long lines!) m Lines at gas stations during 1974 shortage

l Sometimes there might be curtailments and supply rationing m Natural gas shortage of the mid 1970s

l Producers typically lose, but some consumers gain. Some consumers lose.

Price Controls and Natural Gas Shortages

l In 1954, the federal government began regulating the wellhead price of natural gas

l In 1962, the ceiling prices that were imposed became binding and shortages resulted

Price Controls and Natural Gas Shortages

l Price controls created an excess demand of 7 trillion cubic feet

l Price regulation was a major component of US energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s